Sources of Capital - Commercial Banks

Commercial banks are widely known as a source of debt
financing for businesses. They generally provide lines of credit, term
loans, and revolving loans. Traditionally, commercial banks are cash
flow lenders and view collateral as a secondary source of repayment;
however, from experience, bankers' actions do not always evidence this
thinking. Focus is placed on lending to borrowers that have durability
and predictability of cash flows.

To ensure liquidity and stability for the public, banks are
highly regulated by state banking commissions or similar bodies, the
Federal Deposit Insurance Corporation (FDIC), and by the Office of the
Comptroller of the Currency (OCC). Banks are scrutinized for base
capital, profitability, liquidity, credit quality, and management, and
are required to monitor and rate each loan with quality codes or risk
ratings. These codes are established by the bank and relate to, among
other things, the type of collateral, loan-toasset value, cash flow
coverage, and guarantees. Combined, these impact the price charged a
borrower, or cost of capital or interest rate, and the status of the
loan in the bank's portfolio.[1]

Bank regulators can force a bank to place a loan in nonaccrual
or write down a fully performing loan if some factor is of concern to
them. This regulatory control is a large determinant of what might be
deemed an acceptable risk.[2]
This mode of operation coupled with the commodity nature of the banking
business translates into a relatively conservative posture inherent in
the culture and mind-set of bankers in relation to growth
companies-especially given that most growth companies consume cash,
rather than generate it. For start-up companies, collateral becomes
more important given that most fail within the first five years.[3]

Most loans are made based on historical financial performance
and minimum asset collateral values. The decision to lend is based on
the three Cs of credit: character, collateral, and capacity, where
capacity is the ability and willingness to pay.[4]

The bank is not an investor, nor do the bank's returns justify
accepting significant risk. Banks are essentially the lowest-risk
lenders. You will find that most banks will not lend to a company with
a debt-to-equity ratio greater than 2.0 to 3.0 without some additional
guarantee or collateral.

This is the converse of asset-based lenders (ABLs), which
primarily make their lending decisions based on the quality of the
underlying assets and secondarily on cash flow. There are many
specialty lenders and commercial finance companies that provide various
forms of debt; these lenders tend to understand a specific form of debt
exceptionally well and have the business processes in place to manage
their risk, or they have expertise in a specific industry and have
adjusted their lending program and structure to accommodate the nuances
of that business.

It is important to note that many larger regional and national
banks now have asset-based lending divisions as well as capital market
groups that provide private equity. A key in selecting a financing
source is the inherent culture and the actual people with whom you will
interface and those who make the decisions affecting your relationship
with them. We recommend that you determine the work experience and
background of the lending team assigned to your company. Most
commercial bankers turned asset-based lenders do fine in a relationship
until the client's business has difficulties or goes sideways. Then
they revert to their instincts, which may be much more conservative.
This is not necessarily bad, except that a kneejerk reaction may be to
push your company to take action that is not in its best interest; the
bank may call your line of credit and force you into a reactionary
mode.

Now the converse argument: Many of the major banks have
acquired strong and credible asset-based lending firms and have allowed
them to maintain their autonomy. These lenders bring the expertise,
temperament, and monitoring processes as true asset-based sources of
finance. We advocate knowing your lender and what his true disposition
is relative to what your business is likely to need with regard to its
size, stage, and industry.

Confidence in a company and its management is developed from a
variety of sources. Many times it begins with referrals from known
professionals such as attorneys and accountants, and is coupled with
the quality of financial data; over time it is a function of doing what
you say. As with many other sources of capital, banks tend to look at
the background and depth of management, management's focus on the
customer, the type of customers and the company's value to them, why
customers buy from the company, and a thoughtfully developed and viable
business plan. Lastly, banks look for management that is willing to
"work through the tough times."[5]
For many lenders, their greatest fear is how management will act when
the business goes sideways or into the ditch.

Financial covenants should be more important to company
management than the interest rate or up-front fees charged in
establishing a credit facility with a bank. The financial covenants
need to be structured in a manner that will provide the least
constraint given a company's business and operations. It is difficult
to foresee the future and foretell a problem that does not exist today
but could be one tomorrow. Covenants have often forced companies to
take action that was not good business in order to avoid defaulting on
the loans; you want to avoid this.

The next logical topic surrounds the use of personal
guarantees. Our collective experience shows that banks will request,
and many times require, personal guarantees from the principals and
management of emerging growth and middle-market client companies. These
guarantees usually include spousal guarantees where the bank is looking
to personal assets as backup collateral. Guarantees are usually
intended to assure that management does not walk away or abdicate their
responsibility to the bank when trouble occurs within the company. A
principal's personal guarantee gives the lender comfort that when the
going gets difficult, the principal will remain committed to corrective
actions or an orderly liquidation.[6]

Strategies for Structuring Personal Guarantees

Developing an effective strategy for structuring and managing
the personal guarantee begins with understanding your lender's
objectives and perspective. Next, it is important to understand your
company's current and forecasted financial position relative to
liquidation under federal bankruptcy laws.

A philosophy we promote is that of isolating the risk of your
business from personal assets, even when personal guarantees are
involved. This requires personal and business financial planning. If
you are a significant shareholder and manager of an emerging growth or
middle-market company, and anticipate you will be required to sign a
personal guarantee, you may consider engaging counsel that fully
understands personal and corporate bankruptcy. As an individual, this
counsel should not also be counsel to your company, in order to prevent
the conflict of interest inherent in the discussions. Conversely, we
recommend the same from a company perspective: that you have
experienced bankruptcy counsel to review your debt strategy. We
discussed the concept of a liquidation balance sheet in more detail in
Chapter 4 of the Handbook
of Financing Growth.

Here are six proposed actions to consider when negotiating the
terms of debt with the bank and other lenders with the general
objective of committing to as little as required when signing a
guarantee:

Pursue a written agreement specifying that certain terms of
the guarantee will change based on improved financial performance of
the company. An example, if your company will have a debt-to-equity
ratio of 3:l post financing, agree to reduce or limit your guarantee
when the company's debt-to-equity ratio falls below 2:l. Also consider
having the guarantee become less onerous over time, based on the bank's
continued relationship with your company.

Seek to limit the guarantee by not having your spouse sign,
so that it is based solely on your personal guarantee. Be prepared to
provide a financial statement showing only your individually owned
assets and liabilities. In most states this limits the risk to only
assets held solely in your name, not joint assets or those of your
spouse.

Seek quantified limits on the amount of the guarantee
either in relative terms or absolute terms. For example, you may have a
line of credit with $2 million total availability. You may seek to
limit your exposure to 20 percent of the outstanding balance or a
maximum of $200,000. This is particularly appropriate with multiple
owners whereby you may seek to limit your exposure based on your
percentage of ownership.

Seek to exclude any assignment or lien on a personal asset
or real estate such as a house or property.

Seek to limit any risk unless you commit a fraud in
managing the business; this is sometimes referred to as a fiduciary
guarantee.

Ensure that the lender must exhaust all remedies against
the collateral underlying the loan before the lender can seek recovery
from the guarantor. Blanket guarantees usually allow the lender to go
directly to the guarantor and ignore the collateral-they will go to the
quickest source of liquidation.[7]

Practically Speaking

Unless the banker feels very comfortable with the operations
and their security, the bank will ask for a guarantee. As a borrower,
you have a choice not to sign, but the bank knows that this is not
likely. At this stage, the bank clearly has the advantage in
negotiations. Unless there has been a trust violated, banks generally
do not like to go after personal assets, particularly homes or
belongings. They want your attention and your best efforts to make the
company successful.

One of the common phrases in banking regarding guarantees is
"Who has whom?" In most cases, the loans far exceed the value of the
guarantor's personal net worth, and often with high net worth
individuals their equity is not liquid; it is in real estate or equity
in private companies. If things go badly, generally it is in both
parties' interest to negotiate a mutually acceptable plan to rescue or
protect the bank and company. If you have signed a guarantee and it is
for a small portion of your net worth, then it is meaningful. If it is
more a multiple of your net worth, then you and the bank need to work
together (and generally the guarantee will be waived over time), which
is what the bank wants anyway. For the bank to be repaid, it needs
management's expertise to resolve the operating issues.

Banking Business

Companies want to develop a good working relationship with a
bank and have an advocate for the company within the bank. We suggest
that you develop a working relationship with more than one bank-not to
play one bank against another, but to mitigate the risk of bank policy
changes and to ensure that your company has alternatives when your
needs may not suit an existing relationship. Banking is built on
personal relationships, and you cannot build a relationship quickly
enough when difficult situations or needs arise. In addition, bank
officers have a high turnover rate and it is difficult to predict when
turnover will occur. So you do not want to be caught in the early
stages of building a new relationship and have a crisis occur.

Sometimes banks get in trouble when bank management leads its
lenders to increase the number of loans on their books at a rapid rate.
This is generally done because their existing loan portfolio cannot
earn enough to fulfill industry earnings expectations. So why do we
care? If your company's loan is one of those that is really marginal in
the bank's normal mode of operation, once the wave of rapid loan-making
is over, your loan may very well be deemed a problem credit-even if you
make all the payments on time. This may lead to pressure from the bank
for you to repay the loan or for you to improve your financial position
at a rate that was not expected. In a worst case, the bank may call the
loan and demand repayment.

There are other instances in the life of a bank and other
macroeconomic issues that sometimes cause the bank to change its
disposition relative to credit risk. Though you cannot control these,
they may affect you and your company.

Lastly, the size of the asset base of the bank matters as you
consider which banking relationship to establish. Each bank has a loan
lending limit per risk (that is, you or your company). If you choose a
smaller bank as your lender, look ahead several years and determine if
their borrowing limit is adequate to support your company's foreseeable
borrowing needs.

Keep in mind that most loan documentation provides demand for
repayment features if the bank feels insecure, regardless of the term
of the loan. This is a very subjective covenant and leaves the company
at risk if it does not have alternatives at hand. Thus we are back to
the recommendation of having more than one banking relationship
established.

Read more about the Sources
of Capital in the
Encyclopedia of Private Equity and Venture Capital

Kenneth H. Marks, CM&AA,*
is the founder and a managing partner of High Rock Partners, Inc.,
providing strategic consulting, investment banking, and interim
leadership services to emerging growth and middle-market companies. As
CEO he founded a high-growth electronics company and, led and sold a
technology business to a Forrune 500 buyer. As adviser, he has worked
with managers and board members ro develop and implement growth,
financing, turnaround, and exit srrategies in over two dozen companies.
Marks' past positions include president of JPS Communications, Inc., a
fast-growth technology subsidiary of the Raytheon Compnny, and
president/CEO of an electronics manufacturer that he founded and grew
to $22 million.

Mr. Marks created and teaches an MBA elective titled
"Financing Early Stage and Middle-Markct Companies" at North Carolina
State University; and created and teaches "Managing Emerging Growth
Companies," an MBA elective, at the Hult International Business School
in Boston (formerly the Arthur D. Littlc School of Management) in
connection with Boston College's Carroll School of Management. He is
the author of the publication Strategic Planning for Emerging Growth
Companies: A Guide for Management (Wyndham Publishing, 1999).

Mr. Marks was a member of the Young Presidents Organization
(YPO); the founding YPO Sponsor of the Young Entrepreneurs Organization
(then YE0 and now EO) in the Research Triangle Park. North Carolina
Chapter; a member of the Association for Corporate Growth: and a member
of the board of directors of the North Carolina Technology Association.
Marks obtained his MBA from the Kenan-Flagler Business School at the
University of North Carolina in Chapel Hill.

Larry E. Robbins is a founding
partner of Wyrick Robbins Yares & Ponton LLP, a premier law
firm locared in the Research Triangle Park arca of North Carolina. He
is a frequent lecturer on the topics of venture crlpital and corporate
finance and serves on the boards of directors of entrepreneurial
support organizations, technology trade associations, and charitable
and arts organizations. Mr. Robbins receivcd his BA, MRA, and JD from
the University of North Carolina at Chapel Hill. He was also a Morehead
Scholar at UNC.

Gonzalo Fern ndez is a retired
vice president and controller of ITTs telecom business in Raleigh,
North Carolina. Subsequently he spent 15 years working as a finance
executive for emerging growth companies and as an accounting and
business consultant to other companies. He is a past president of the
Raleigh Chapter of the Institute of Management Accountants. He received
his BA in accounting from Havana University, Cuba. He wrote the book Estados
Financieros (Financial Statements) (Mexico: UTEHA, third
edition, 1977).

John P. Funkhouser has been a
partner with two venture capital funds, and operated as chief executive
officer of four companies in a variety of industries from retail to
high technology. In his venture capital capacity, he was a corporate
director of more than a dozen companies and headed two venture-backed
companies. The most recent company he led from a start-up concept to a
public company is a medical diagnostics and devices business. Mr.
Funkhouser worked in commercial banking with Chemical Bank of New York,
in investment banking with Wheat First Securities, and in venture
capital with Hillcrest Group. He has an undergraduate degree from
Princeton University and an MBA from the University of Virginia, Darden
Graduate School of Business Administration.

D. L. "Sonny" Williams is a
managing partner at High Rock Partners. As CEO, for over 25 years he
led three global manufacturing/technology companies through major
transitions; and as an adviser, he has worked with companies in
numerous industries to create value and implement change. Mr. Williams
has over 30 years successful operating experience in engineering,
manufacturing, sales/marketing, and senior executive roles. His career
is highlighted by having led the turnaround of three global
manufacturing/technology enterprises ($50 million to $330 million in
revenues in nine countries) over a 20-year span in
CEO/president/director roles, serving the automotive, consumer,
industrial, aircraft, and medical component markets. Mr. Williams'
leadership accomplishments include successfully achieving dramatic lean
enterprise-based cost restructures, low-cost country
expansions/sourcing, and accelerated organic growth through strategic
value proposition repositioning; complemented by leading eight
acquisition/ merger/joint venture-related negotiation/lintegrations.
Mr. Williams' value-creating experiences were magnified by successfully
repositioning two of the corporate companies for investment-attractive
management buyouts.

Mr. Williams received his BSEE from Kettering University and
his Executive MBA from the Kenan Flagler Business School at the
University of North Carolina, Chapel Hill. He is president of the
Association for Corporate Growth (Raleigh-Durham chapter) and a member
of the National Association of Corporate Directors.

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